Home Equity Line Of Credit: Friend Or Foe?
Last month, the Bank of Canada issued a report highlighting the explosive growth of home equity line of credit use and mortgage refinancing in the past decade, which have surged from $8 billion in 2001 to $64 billion in 2010.
Canadians appear to be using these loans for two main reasons. They are either paying down other higher interest loans, such as credit card debt, or using the money for everyday spending.
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My first experience with a home equity line of credit was back in late 2005. After buying a house two years earlier, it surged in value during the economic boom in Alberta, rising from $129,000 to $190,000.
Using a Home Equity Line of Credit to Consolidate Debt
At that time, my wife and I still owed tens of thousands of dollars in student loan and credit card debt, so we took out a home equity line of credit to consolidate most of our debts. This was a smart decision that helped save us a few hundred dollars in monthly payments by lowering our overall cost of borrowing.
Just be cautious when using this approach. You still need the discipline to repay the line of credit or you might find yourself right back where you started.
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Our $25,000 credit line was borrowed at prime rate, and two years later we rolled the loan back into our mortgage at renewal time. The bank didn’t close the line of credit after this. Instead, they suggested we keep it open just in case something comes up.
Using a Home Equity Line of Credit as an Emergency Fund
Our finances weren’t perfect by any stretch. One or two missed pay cheques would have caused serious damage to our finances. However, building a cash emergency fund never became a priority for us because we knew we had a line of credit to fall back on.
So for the next five years our home equity line of credit remained untouched and we resisted the urge for that something to come up. During that time, I convinced myself that a home equity line of credit was the perfect emergency fund. Here’s why:
- A line of credit is the most affordable way to borrow for short term needs – with rates as low as prime or prime + 1%
- Accessing funds from your line of credit (once it’s set-up) is as simple as making a transfer online
- Re-payment of your line of credit is very flexible – you can pay as much or as little as you like.
- The opportunity cost of carrying thousands of dollars in a so-called high interest savings account did not seem appealing.
Using a Home Equity Line of Credit as an ATM
Meanwhile we watched as our friends and colleagues (and the rest of the country) tapped into their credit lines like a giant ATM and use it for home renovations, new vehicles, family vacations or to further their education.
In The Wealthy Barber Returns, author David Chilton writes that with our increasing debt load and infatuation with buying stuff, not only is a line of credit a bad idea, but it’s leading to over-consumption and we’re now carrying debt along side of our savings.
HELOC: Friend or Foe?
A home equity line of credit has its advantages. It’s an easy way for homeowners to consolidate high interest debt. When used responsibly, an untapped line of credit can make for a good safety net in case of emergency.
However, the easy access to credit and flexible repayment terms can make HELOC’s very dangerous. Many consumers dip into their line of credit and then quickly find themselves living at their limit. Then when the money runs out, they increase the credit limit and repeat the cycle.
Our home equity line of credit was closed when we sold our home last year. We rented for three months while our new house was being built, and over that time we saved up a few thousand dollars that we now keep in a high interest savings account.
We no longer have a line of credit, even with more than 25% equity in our home. Our new financial plan includes keeping cash reserves on hand rather than relying on a line of credit for emergencies. We want to pay cash for any major purchases in the future, like for a new car, basement renovations or a big vacation.
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For many people, a home equity line of credit is an easy way to fall into a debt trap. Be cautious. Don’t use a HELOC to continue increasing your debt load or to support a gap between your income and expenses.
Some have used HELOC to invest in their businesses too.
It is not the line of credit or credit card that is the problem. It is the individual who uses it! You need to learn how to use these financial instruments responsibly or not use them at all.
Don’t you think it would be better to pay down your mortgage with the money you would otherwise be putting into an emergency savings account? If you need emergency funds, then you take them from your HELOC. The downside to this is if you lack discipline to increase your mortgage payments and/or discretion when it comes to pulling money out of your HELOC.
I mean, really the concept of “cash” is a bit moot so long as you have a mortgage. If you own $300,000 to the bank for your house mortgage what kind of satisfaction is there in saving up $500.00 in a savings account? Might as well pay down your principal with the so-called cash. If you desperately need funds at some point, take them out from your HELOC and feel the pain then — meanwhile you’re saving money on the interest you would have been paying on your surplus.
@Tom – I definitely hear what you’re saying. We have a plan to pay off our mortgage in 15 years (or less) and we’re paying an additional $800/month on our mortgage to try and get there.
I use a zero-based budget, which means I’m putting every single penny we earn towards an expense or savings category. Having an extra few thousand dollars kicking around is handy in case my budget is off the mark one month, or if our business income comes in lower than anticipated.
So I’m using the cash as a buffer rather than a true emergency fund.
And since the interest rate on our mortgage is 2.20%, there’s not much difference versus holding cash in a savings account.
Most of the HELOCs typically have a lower fee structure than other types of refinancing loans, it’s why people choose them. But yes, people should be cautious when choosing to use them. If used in wrong situation, they can hurt for sure.
P.S. Nice, detailed article. Clarified some things to me.
Great advise it isn’t for everyone and if you don’t do your research you could get yourself into more mess. Some people also take the lines of credit for the wrong reason.
HELOCs when used responsibly can provide the financial safety net that one may need. Most Lenders allow you to convert all or any portion of your HELOC balance to a fixed option which locks in a fixed interest rate for a closed term of 1-5 years. This protects you from interest rate increases and establish regular fixed payments to help you plan your budget.
This can be a good solution to having access to the financial safety net if ever needed, with the comfort of knowing that you’re paying down your debt responsibly.
IMO, carrying non-deductible debt is always a bad idea, with the possible exception of a first mortgage but even that is a major risk in an era of low interest rates and high urban housing prices. At the end of the day, you’re living a lifestyle you can’t afford and sacrificing your future (and your kid’s future) to do so. I’m a bit of a hard-ass financially (excuse my French) but the whole “live for today” ethos really rubs me the wrong way. Sure I could get hit by a bus tomorrow, but at least I won’t have to worry about my family’s future well-being. Besides, the stress of carrying debts you have to service over a long period of time will shorten your life, guaranteed.
Personally, I’ve used a HELOC to modestly leverage an investment portfolio but even that is becoming questionable in an era of low returns. That said, it is still a legitimate strategy if you have the risk tolerance and wherewithal to do so. The HELOC will ensure that you get the lowest interest rate (shop around!) keeping your expenses as low as possible and the interest is tax deductable (at your highest rate) as long as the money is invested to earn income (i.e. most stocks, bonds or, theoretically, many options).
Leverage works best if invested conservatively for the long term so that you can ride out market cycles. A diversified portfolio of blue chip, dividend paying stocks with DRIPs work well, do not buy mutual funds! You are magnifying your risk considerably by borrowing to invest, don’t make it worse by attracting more expenses or speculating on junior resource stocks. To keep it cash flow neutral, my rule of thumb is that income (dividends) should cover interest payments (very easy to do in this environment) but don’t overdo it. Interest rates can rise considerably faster than dividend yields.
Using a HELOC for this purpose is obviously not for everyone, but if you have a solid regular income and little or no debt, it will enhance your long term financial health and offers the prospect of financial independence.
You’re talking about using a HELOC to make money — whether “leveraging” to buy some crappy stocks, or (a better idea) building a real business of your own. Sure, why not.
It’s sure way better than borrowing money so that you can have a 128″ plasma screen TV or go to Cancun while you still have a $500,000 mortgage.
But… anyone who buys anything while they still have a mortgage is, in reality, buying on credit. Cash is only cash when you don’t owe anybody anything.
“whether “leveraging” to buy some crappy stocks, or (a better idea) building a real business of your own.”
My point was to avoid buying “crappy stocks” as it magnifies risks that are hard to justify. Buying quality blue-chip, dividend paying investments that you know and understand carries less risk than trying to run your own small business which statistically has a much higher failure rate.
Owning a business usually requires most of your time and effort to be successful and you don’t need a HELOC to attract capital or take on debt with a sound business plan. The strategy I describe is suited more to wage slaves with an interest in the markets but managing an investment portfolio should be approached in the same way as running a business; keep costs down, cash flow positive and tax efficiency in mind.
I’m a bit late to comment, but we’ve used two HELOCs to snap up income real estate in under-priced markets (and they still do exist). One property has appreciated on paper more than the HELOC in one year plus it generates a minimum positive cashflow of $500/month. While real estate pricing is generally inversely proportional to interest rates, there are some exceptions due to local cyclical economic factors and using almost free money to invest makes sense – as long as there is a plan to repay before interest rates rise again.